South Africa's Recession Continues Even as the Rand Surges

"The banking sector in South Africa has insubstantial leverage and did not enter in to excessively risky lending practices that were the hallmarks of the credit-boom days. However, South Africa’s Current Account Deficit remains wide and its ability to service its short-term debt is on the wrong side of comfortable. These factors, along with the size of the banking sector in relation to that of other emerging markets, would bring unwelcome attention to the economy in the event of a deterioration of global risk sentiment (perhaps precipitated by a sovereign debt crisis elsewhere in the world)."Simon White - Variant Perception

Summary

As was expected by most analysts, South Africa's GDP shrank in the second quarter of this year at an annualized rate (q/q saar) of 3% over the first quarter (which represents an actual seasonally adjusted shrinkage of 0.75%) as compared to the 6.4% rate (1.6% actual) seen in the first three months of the year. The improvement in GDP was largely due to better performance in mining, manufacturing and the energy sector. Activity declined 2.8% year on year from the 1.3% drop recorded in Q1 2009. Agriculture was a serious disappointment, with a 17% (q/q saar) from a 2%(q/q saar) drop in Q1. Evidently the pace of decline is easing, mainly due to expansionary fiscal measures and an increasingly accommodative monetary policy and in part to the impact of what have become colloquially known as global green shoots (that is demand stimulus from other countries). The figure is unlikely to significantly influence interest rate decisions next going forward as it was broadly in line with consensus expectations, and was effectively factored in at the last RBSA monetary policy meeting. Going forward, downside surprises on inflation and continued weakness on real economy could potentially lead the Reserve Bank to further reduce interest rates.

click to enlargeThe Analyst View

Cees Bruggemans, First National Bank: "Q3 2009 will be a transition quarter, between the recession proper (4Q2008 and 1H2009) and the recovery proper in GDP growth (Q4 2009).Interest rate-sensitive sectors should benefit from the cumulative 500 point interest rate easing since December 2008." (18 August, 2009)

Danelee van Dyke, Standard Bank: "The prospects for rejuvenation in depleted inventory levels, a catalyst for a rebound in production should bolster the economy’s growth potential in the second half of the year." (18 August 2009)

Overview

South Africa's economic performance has steadily been strengthening recent years, with real GDP growing at an annual average rate of 4.6 percent in the years between 2005 and 2008. Inflation had declined to mid-single digits and employment had been growing steadily. Growth in recent years has been driven by strong domestic demand, with private consumption and investment spending supported by robust consumer and business sentiment. Household consumption was also boosted by growing disposable income, rising employment, and wealth effects from rising asset prices until late 2007.

However, 2008 saw a slowdown in activity reflecting the cumulative impact of electricity power shortages, the global slowdown, and a policy of monetary tightening. Real GDP growth slowed to 3 percent as the country entered recession.The deceleration in the pace of growth is clearly seen in the in the evolution of the Reserve Banks preferred measure of money supply (M3, see chart below which comes from the RBSA) with increases slowing substantially after Q4 2007, but with the slowdown clearly deepening in early 2009. Twelve-month growth in M3 decelerated from 14.8 per cent in December 2008 to 10.6 per cent in March 2009 and further to 8,5 per cent in April. On a quarter-to-quarter3 basis, M3 growth amounted to 4,1 per cent in the first quarter of 2009; down from 15,1 per cent in the fourth quarter of 2008.Comparing this year's first half with that of last year, the economy is down only 2%. It is expected to stabilize next quarter, and move back into growth by the fourth quarter, making it unlikely that the full-year decline will be as bad as the 2% plus that more pessimistic economists had predicted. Excluding the volatile agriculture and mining sectors the economy actually improved by as much as four percentage points to minus 2.4% in the second quarter from minus 6.2% in the first quarter.

Construction, government and personal services (such as healthcare) carried what growth there was, and export-oriented sectors of mining and manufacturing did better than in the previous quarter. But the big disappointment was the retail and wholesale trade sector, which did far worse than expected and the decline accelerated to 4.5% in the second quarter from 2,5% in the first. The manufacturing sector continued to contract in the second quarter, but the 10.9% drop should be seen against the first quarter's steep slump of 22%. The financial sector also contracted again, by about 2.5%.

Mining expanded 5,5% after the first quarter's 32% fall as it started to benefit from better commodity prices.

Unemployment Continues to Be A Major Problem

South Africa's unemployment rate increased very slightly - to 23.6% in the second quarter from 23.5% in the first quarter of 2009 - what is perhaps surprising is that this was despite the fact that 267 000 lost their jobs during the quarter. Part of the explanation for this is that the number of discouraged work seekers rose by 302 000. Had that number been added to the unemployment total, the result would have been an unemployment rate of more like 29.7% (compared to an equivalent calculation of 28.4% in Q1 2009).Most importantly, the latest rise takes the total number of discouraged workers to 1.5 million from 1.1 million in Q2 2008. As a result the number of people who are not economically active in the working age range increased to 13.58 million, from 12.86 million in Q2 2008 with the consequence that the economically inactive population, of which discouraged workers form 11.2%, is currently larger the employed workforce and almost one and-a-half times the size of those in formal employment.

Retail Sales Continue To Fall

Price adjusted retail sales decreased in June by an annual 6.7% following a 4.4% drop in May. For the three months to June, sales contracted by 6% relative to the corresponding period a year earlier . Anxiety about job security, comparatively high levels of household debt, still high inflation which is still relatively high and a low level of consumer confidence are the likely reasons for the negative growth in real retail sales and this may well continuer for most of 2009. Ultimately declining interest rates, lower inflation and improved household balance sheets should see a recovery in retail sales in early 2010.

The household debt-to-disposable income ratio continued to rise in the first three months of the year - if only marginally to 76.7% from 76.3% in the last quarter of 2008 - implying that financial strain on households remained significant. Debt consolidation should gain traction during the second half of the year, when the debt service cost-to-income ratio falls to around 8% from its current level of 10.9%, at the same time as lower inflation frees up some additional cash in the household sector.

While Manufacturing Struggles

Although the final result was not as bad as many expected, manufacturing production still fell by an annual 17.1% in June, little changed from the downwardly revised 17.2% contraction in May. South African industry still appears to be in the throes of an inventory stockpiles rundown. Iron and steel were down 24.3%, the automotive sector 32.8%, and petroleum and chemicals were down 14.7% . Output did increase by a miniscule 0.1% seasonally adjusted between May and June, but more to the point the rate of contraction in production did slow down significantly in the second quarter, showing minus 3% q/q s.a. as compared with minus 6.9% q/q s.a. in Q1.

Encouragingly, electricity consumption, often a useful indicator of economic activity, rose in June by 1% over may (s.a.) and by 2.9% (s.a.) in Q2 over Q1, which would seem to confirm that the recession eased markedly in Q2. The latest manufacturing purchasing managers index reading, however, did not give as much grounds for optimism as might have been hoped for, since the PMI weakened in July to 37.3 from 37.9 in June following two consecutive monthly gains, suggesting the rate of contraction in manufacturing activity accelerated again, even if only slightly.

The weakening was pretty broad-based, with business activity, new sales orders, suppliers performances and input prices falling in the month.

In fact South Africa’s manufacturing PMI seems to be lagging the PMIs of the country's major exporting partners (US, Germany, Japan and UK) by two-to-six months. While these economies reached the troughs in their PMIs between November 2008 and February 2009, their PMIs have rebounded nearly seven times as much as the South Africa one, since hitting their respective troughs. This suggests that by October the decline in production could be over and out of the system, provided that is that the slow but steady recovery in the three above mentioned economies continues, which is far from guaranteed.

Inflation Still A Problem

The inflation measure targeted by the South African Reserve Bank until the end of 2008 was the consumer price index excluding mortgage interest costs for metropolitan and other urban areas (NASDAQ:CPIX). The year-on-year inflation rate as measured by CPIX peaked at 13.6 per cent in August 2008 and then declined continuously to 10.3 per cent in December. According to the central bank the main drivers of inflation during the last quarter of 2008 were food prices, fuel and power (electricity prices), and transport (petrol prices). Average CPIX inflation for the calendar year 2008 was 11.3 per cent.Since the release of the January 2009 CPI data, the targeted inflation measure has been the headline CPI (CPI for all urban areas). This new CPI includes a number of changes of methodology when compared to the previous CPI. The year-on-year CPI inflation rate was 8. 1 per cent in January 2009. It then rose to 8.6 per cent in February before declining marginally to 8.5 per cent in March (Figure 1). Inflation in the first quarter of the year was driven mainly by increases in food prices, alcoholic beverages, household maintenance and repair, electricity, and in financial services.

Since that time the inflation rate has fallen back slightly - from 8.0 per cent in May 2009 to 6.9 per cent in June - but given the extended recession and the low levels of capacity utilization this rate is still noteworthy for its size. One of the underlying problems is evidently still the rate of administered price inflation, which (excluding petrol prices) was running at 9.1 per cent in June, with electricity prices increasing by 28.6 per cent.

Producer prices, on the other hand, do show the impact of the fall in energy prices and the economic slowdown, since they declined at a year-on-year rate of 4.1 per cent in June, compared with a decline of 3.0 per cent in May. Prices of mining and chemical products were the main contributors to this trend, but there was also further moderation in food price inflation.

Interest Rates In A Bind

Basically, having headline CPI inflation still running at 6.9 percent is something of a headache for the central bank, since given the recession they would evidently like to ease more (which would also help take some of the upward momentum out of the Rand), but the bank will be wary of going too far, given the extent to which its credibility will be under test. South Africa’s central bank unexpectedly cut its benchmark interest rate by half a percentage point, the sixth reduction since December, to curtail the economy’s first recession in 17 years. The repurchase rate was lowered to 7 percent. Governor Tito Mboweni said in a televised statement after the monetary policy meeting that the decision to reduce rates had been a “very closely debated one”, and it seems unlikely that further rate cuts will follow rapidly.

Carry Trade Monetary Policy Dilemma

The problem is that the central bank is on the horns of a real and very important dilemma here, as it struggles to apply text book inflation targeting monetary policy in times which are most definitely not of the text book variety. One of the issues is that interest rates which are set high to contain inflation can often have the perverse effect of attracting fund flows which are drawn by the yield differential, and the expectation of further currency appreciation (among other things South Africa's is a commodity producing economy) - and the swift reversal of the fund outflows witnessed last winter (see chart below) gives some hint that this kind of counter intuitive effect may now be at work in South Africa. Thus South Africa’s rand, despite the current severe recession, has in fact been the second best-performing currency, after Brazil, across the globe this year. But is this impressive performance of the ZAR supported by the underlying macro fundamentals? Negative growth, depressed confidence and steadily rising unemployment certainly do not make it look like it is.

The rand appreciated the most in a month against the dollar last week - maintaining its first weekly advance since July 24 - on the back of consensus feeling the global economy is moving out of recession, increasing appetite for high-yielding assets. On Friday (August 21) the currency strengthened by as much as 1.9 percent to 7.7474 per dollar, its biggest intraday jump since July 20 and best level since Aug. 4. It was up 1.1 percent at 7.8139 per dollar as of 5:06 p.m. in Johannesburg, for an increase of 3.4 percent over the week.

The rand has now climbed 21 percent against the dollar this year as benchmark interest rates fell to near zero in the U.S. and Europe compared with 7 percent in South Africa, making the South African currency a favorite for the so called carry-trades where investors borrow money in countries with low interest rates to invest in markets with higher returns. The rand offered the third-best carry-trade return of the 16 major currencies monitored by Bloomberg last week.

Much of the ZAR move has been closely correlated with the return of investor risk appetite. One of the main catalysts for this has been the upside surprise from US economic data (as Varinat Perception's Simpon White put it the second derivative of the data turned positive while the second derivative of the consensus estimates remained in negative territory).

Unsurprisingly, as Simon points out, there is a very good fit between ZAR and the Citigroup US Economic Surprise Index (this measures the degree of "surprise" in the data releases). This close relationship simply serves to emphasize the seductive power of emerging markets to investors – now wallowing in liquidity. In fact the ZAR has moved more closely with unexpectedly good US economic data than either the S&P or US 10y Treasury yields. This liquidity-driven geared-play on emerging markets is now a central part of the global recovery. A softening attitude to the prognosis for the South African economy is also reflected in risk spreads. Sovereign CDS continues to fall, approaching levels seen last summer, and the spread between South African and US 10y Treasury yields has returned to its average over the period late 2007 to the present.

The stock market has also bounced back, and is so far up 36% from the trough. With the rally in equity markets that began on the 6th of March this year and on the 13th of July continued with renewed vigor, money inflows to South Africa began to recover after a sharp rout in the fourth quarter of 2008.

In fact there was huge net outflow of portfolio flows in Q4 2008 which quickly reverted to a net inflow in Q1 2009. The current account deficit as a whole – perennially wide in South Africa - narrowed from a low of -8.8% of GDP last March to -5.8% in the last quarter of 2008, driven in part by falling import prices (primarily oil). More recently the deficit has widened again due to mining and manufacturing exports falling faster then imports. Further widening in the current account deficit from this source will likely be limited as the trade balance has recently improved somewhat (but due to falling demand for imports rather than an increase in export trade). On the positive side, the composition of South Africa’s relatively large current account deficit looks healthier than in previous years as net foreign direct investment has improved dramatically: it was over 100bn ZAR in 2008 compared to an average of close to zero in the preceding 3 years.

The Liquidity-Driven Gearing-Play Is Certainly Bad For SA Exports

With almost half of South Africa's goods exports destined for the US, Europe and Japan, the recession in the developed economies has naturally severely affected South Africa's trade performance. But with the real effective exchange rate of the rand also increasing - according to central bank data it was up by 4.9 percent between March 2008 and March 2009 - then evidently South Africa's exporters are facing a price competitiveness problem.

So it is no surprise to find that the volume of goods exports was down at a 21 percent annualized rate in the first three months of 2009, and this on the back of a decrease of 6.3 per cent in the fourth quarter of 2008. Relative to real gross domestic product, the value of goods exports dropped from 20.8 per cent to 16.7 per cent during the first quarter. Although declines were noted in all major export categories, the decrease in the volume of manufactured exports was strongly related to the sharp contraction in manufacturing activity among SA's most important trading partner countries. In addition, the deceleration in the Chinese demand for raw materials used in production processes had a negative impact on South African mining products.

As a result, it is understandable that the country's goods trade deficit was widening - from R19,6 billion in the fourth quarter of 2008 to R53,4 billion in the first quarter of 2009. A trade deficit of similar magnitude was last recorded in the first quarter of 2008 as a result of the fact that the country experienced severe power outages. South Africa’s government is no so concerned about the situation that Economic Development Minister Ebrahim Patel warned last week that the current recession might irreparably erode the country’s manufacturing capacity.

“We are deeply concerned about a permanent decline in productive capacity as factories close rather than simply reduce output,” Patel said to the South African Parliament, "Manufacturing output has been declining since mid-last year. It has now reached levels last seen some five years ago.”

All of which naturally enough feeds directly through to the pretty substantial current account deficit.

Credit Pinch?

Credit growth in the private sector has slowed substantially, and while it still remains positive, it has now dropped from a 20.3 percent in the year ending in June 2008, to more like a 5% annual rate of increase in June 2009. Household debt rose slightly to a record level of 78.25 percent of disposable income by the first quarter of 2009. Pushed mainly by rising interest rates, household debt service has risen to about 11.25 percent of disposable income, but remains below historic highs. Total loans and advances extended to the private sector continued to decelerate in the first quarter of 2009. The deceleration was partly a consequence of the decline in income and deteriorating outlook for economic activity, restrictive credit conditions and the cumulative effect of the tighter monetary policy stance introduced since 2006.

Growth over twelve months in total loans and advances extended to the private sector decelerated from 14.0 per cent in December 2008 to 7.3 per cent in March 2009, and further to 6.3 per cent in April. The annualized quarterly growth fell from 6.2 per cent in the final quarter of 2008 to a mere 0.1 per cent in the first quarter of 2009 – the lowest rate since the first quarter of 1966, when this rate was negative.

Adjusted for inflation, loans and advances have contracted significantly in recent quarters. With the exception of mortgage advances, all the other main credit categories contracted in the first quarter of 2009. Mortgage advances, which comprise about 52 per cent of total loans and advances, continued to rise, but their twelve-month growth rate decelerated from 13,2 per cent in December 2008 to 11,3 per cent in March 2009 and further to 10,6 per cent in April as stricter lending criteria and higher deposit requirements by the banking sector continued to dampen mortgage business, especially residential mortgages.

Not surprisingly, given the economic and credit environment, South African house prices have been falling, and were down 4.2 percent in July from a year earlier, according to Absa Group Ltd., the country’s biggest mortgage lender. The average nominal house price dropped to 925,100 rand ($115,548). Prices fell 0.2 percent in the month, after declining 0.4 percent in June. After gaining 3.7 percent in 2008, house prices will probably fall between 3 percent and 3.5 percent this year, according to the Absa Group forecast.

Twelve-month growth in installment sale and leasing finance has also slowed noticeably and showed negative growth of 0.2 per cent in April 2009, largely reflecting the slump in sales of motor vehicles and other durable goods. Other loans and advances contracted for the second consecutive quarter in Q2. Twelve-month growth in other loans and advances decelerated from 17.9 per cent in December 2008 to 3.9 per cent in March 2009 and further to 2.8 per cent in April.

Demographic Processes Favorable, But Massive Strain On The Labour Market

Demographic processes are now very favorable to South Africa, as fertility declines, and the median age of the population steadily rises, and more and more of the population are to be found in the working age ranges. This creates the favorable situation where the country can reap the benefits of what is known as the "demographic dividend", as the percentage of dependent population steadily falls.

However, this process puts enormous pressure on the labour market, as more and more young people enter looking for work. As can be seen in the chart below, South Africa's working age population is increasing at a rate of 375,000 a year, or nearly 100,000 a quarter. That is a lot of jobs to find.

But, as we can see in the next chart, due to the recession employment actually fell between Q4 2008 and Q1 2009, while over the course of Q2 2009 it more or less moved sideways. Little wonder there is such a large problem of "discouraged workers."

The Immediate Future

The current protracted recession is putting substantial pressure on the South African administration and is increasingly calling into question president Jacob Zuma's pledge in May to create half a million job opportunities by the end of 2009 through public-work programs. At the same time the deterioration in South Africa's labor market has both weighed on consumption and deteriorated the level of credit quality.

Economic growth is expected to return slowly - especially given the credit squeeze, which is of course reflected in the weak performance of retail sales. The economy is expected to contract by 0.3% this year by the IMF, but many expect the contraction to be nearer 1.5%. Standard Bank anticipates formal job losses totaling more than 400 000 in the current cycle and then -depending on the duration of the economic slump - further job losses which will evidently hamper economic growth. Such labour market trends will also have negative knock-on effects on household spending and income growth. Soft labour market conditions could aggravate the current contraction in real disposable income growth, also affected by a sharp decline in bonus payments, operating hours, and lower property income, and this trend is likely to endure for at least another six months.

At the same time there will be growing pressure on the fiscal side. South Africa’s borrowing needs are likely to be double the government’s projection according to estimates from JPMorgan Chase & Co. They suggest government borrowing may surge to 183 billion rand ($22.4 billion) in the 2009-10 fiscal year to cover spending, compared with the forecast of 90.37 billion rand outlined in its February budget. If confirmed this would increase the budget deficit to 7.4 percent of gross domestic product, compared with a government forecast of 3.8 percent, she wrote.

“The increased borrowing will be driven predominantly by a revenue shortfall rather than over-expenditure. The economic recession is taking a bigger toll on the fiscal position of South Africa than previously thought.”- Sonja Keller, Johannesburg-based economist for JPMorgan

The national government fiscal balance moved into surplus (0.9 percent of GDP) in the financial year 2007/08, bringing the total government debt level down to around 28 percent of GDP. The surplus, the second in a row, reflected a large increase in tax revenue, owing to strong economic activity over most of the period and continued collection efforts. Total public debt, including obligations of public enterprises and local governments, dropped to about 35 percent of GDP.

Sonja Keller estimates that South Africa is likely to miss its 643 billion rand revenue-collection target by between 75 billion rand and 80 billion rand in the current fiscal year (forecasting the economy to shrink by 2 percent). Some confirmation of her view can be found in a recent statement of Finance Minister Pravin Gordhan, who admitted the government may miss its target by as much as 60 billion rand this year.

Pressure on public finances may come from higher wage settlements in the public sector, since civil servants look set to push government expenditure above the budgeted 738.6 billion rand by about 10 to 15 billion rand. South Africa’s government granted a 13 percent wage increase to about 125,000 striking municipal workers on July 31 to end a wage dispute.

In conclusion I see four main downside risks in the South African Economy at the present time:

The current account deficit

The fiscal deficit

The overleveraging of South African households in the context of a weak labour market

The serious structural distortion which can be produced in South Africa's industrial and economic development by the kind of strong geering-related liquidity play to which the country is currently being subjected by the financial markets, since this is producing substantial distortions in relative pricing and in the country's real effective exchange rate, a factor which is critical for those contemplating long term serious greenfield site invement projects.

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